Bond market selloff

Hello and welcome to Global Research Unlocked, the interest rates and FX series. This podcast is based on our weekly client conference call, where our strategists, along with guests from other parts of Bank of America Global Research, discuss the most topical and pressing questions faced by our market. I'm Sfia Salim, head of European rates strategy.

It is Friday, May 22nd, I am joined by different members of the global rates team and the topic of our call today will be on the global bond market selloff and the outlook ahead. The past week has raised indeed the specter of global bond market titters. We are recovering now, but we did see significant bond bearish pressures stemming in particular from three factors, one, some central banks being seen as behind the curve, secondly, concerns over higher bond supply, and third, positioning with maybe some tentative loans being stopped out or CTAs adding to short.

In this call, I want to go by regions and ask different analysts what the view has been on the most relevant drivers to their market and the outlook ahead. So, I'll start with you, Mark, on the US. What do you think have been the most significant drivers of the treasury market selloff late last week and early this week?

Great. Well, thanks, Sfia, and hi, everyone. We think that the US rate move is primarily driven by fundamentals.

We have seen continued positive US economic data surprises, including positive labor surprises, and it's in the context of still very elevated inflation. And we believe that with this backdrop, the market is really reassessing the outlook for Federal Reserve policy. The distribution, I think, in many investors' minds has shifted.

Many are much more open to the idea of potential rate hikes from the Fed and expect that we're going to see a further shift in that direction from Federal Reserve officials, and especially we'll be watching very closely for what we hear from new Fed Chair Kevin Morsh, who we expect will be sworn in in just about two hours' time. So for us, we think that it's more of a fundamental story driven by positive economic data. It does come in the context of ongoing fiscal questions in the US, but at least personally, I'm less willing to overweight those factors, given that we have seen asset swap spreads generally tightening, we don't get the same sort of signal from that that would indicate large fiscal jitters, and instead we overweight the fundamentals, especially given that most of the very recent rate move has been all real rate-led.

How would you say has the outlook evolved in the last few days? Anything challenged there? In the last few days, I would say that we've actually seen the rate move in the US stabilize to some extent, driven by continued headlines that suggest there may be progress in US-Iran negotiations that is in turn allowing commodities to move a little bit lower or stabilize around here.

So that has been one factor that has helped limit the extent of further sell-off. Certainly that's been more of a constructive environment for concerns around elevated inflation, as well as Fed that might feel as though they really need to keep pressing in the shift from a more dovish to neutral and then potentially more hawkish bias. As far as supply and positioning is concerned, nothing terribly notable in the last few days.

In positioning, we do think that CTAs are very short. We think that real money or asset managers have essentially capitulated in their long positions, and we think that active managers are underweight treasuries and overweight spreads, IG and mortgages. So we're not seeing real, let's say, flight in positioning.

We also continue to see ongoing inflows into fixed income. So we don't get this broad sense that investors are fleeing from dollar fixed income. They're just reassessing the fundamentals and choosing to overweight spread product as opposed to treasuries, given how the fundamentals have moved.

Thank you, Mark. Yamashita-san, shifting to you in Japan. There the moves have been even more extraordinary, really, over the past couple of weeks.

So what do you think are the most important drivers there? OK, good morning and good afternoon from Tokyo. And I'm happy to share my views on yen rates and answer to your question.

There have been several catalysts, but I think supply-demand imbalances have been the main driver pushing JGB yield higher so far. As late April to early May was during Japan's national holidays, the May JGB auction schedule has been barely clouded. At the same time, fading confidence in statehood passage through the slate of homes has pushed up inflation expectations in Japan, prompting the offshore investors to unwind flat on a position through mid-May.

Given that Japan imports most of its energy via the homes and foreign investors have been the largest buyer of long-end JGBs through fiscal year 2025, this shift had a notable impact on the market. In addition, why means that Takahashi favors an accommodative monetary policy and the BOJ appears at risk of falling behind the curve. So in short, a clouded auction calendar, concerns about the BOJ falling behind the curve, and position unwind by foreign investors, particularly real money accounts, have driven a sharp steepening of the 530 curve from around 180 bps in early April to about 200 bps now.

Has this outlook evolved a little bit over the last few days? Are you more or less concerned about these factors now? I know Japan still faces upside inflation risks.

That said, the market has already absorbed the 10th, 20th, and 30th year JGB auctions, leaving the May 27th 40-year auction as the only remaining long-end supply event this month. First, the higher coupon should attract domestic real money demand. Second, BOJ Governor Ueda met Prime Minister Takeichi a few hours ago and appears to have received a green light for late hikes.

Recall, best friends visited Tokyo earlier this month and met Takeichi and Finance Minister Katayama. Back in October 2025, best friends met Katayama, followed by Ueda's meeting with Takeichi in November, and the BOJ delivered an additional hike in December. This suggests the market may see less risk of the BOJ falling behind the curve.

Third, the long-end in Japan still looks cheap. In late April, the 40-year yield was around 3.8 percent, but it's now about 4.2 percent. Of course, with the supplementary budget size already reported, but we do not expect it to lead to an increase in JGB auction sizes.

The MOC is expected to reallocate refunding bond issuance to deficit finance bond issuance in order not to increase the JGB auction sizes. Thank you very much, Yamashita-san. Now in terms of moves in the UK, which were also very much fiscal lent, Agnei, is that the main driver, you think, of the gold market at this stage?

Hi, Stea. In the UK, I would characterize the sell-off as driven by a combination of factors, really, broadly along the lines that you have outlined at the start of the call. So first, unlike some other markets, the BOE had not yet reached terminal rates when the Iran conflict began, so the front-end repricing was particularly sharp in the UK.

And UK rates also exhibited higher-than-usual beta to the US during the sell-off, and heavy long positioning ahead of the conflict really amplified this dynamic. And more recently, domestic political uncertainty has also contributed to the sell-off and elevated volatility. So overall, the sell-off that we have seen reflected, I would say, a confluence of factors that have driven the sell-off and volatility in UK rates.

Have things evolved, really, in the past few days that would be more reassuring for UK markets? Yeah. Over the past week, the sharp rally that we have seen actually fully reversed the sell-off that we have seen since 7 May local election.

And this move was driven partially by fiscal reassurances from potential labor leadership contender Andy Burnham, but also softer-than-expected macro data, including March labor market report, April inflation and PMIs. And in terms of our interpretation of the data, and that includes not just the data, but actually other developments such as oil price moves as well, our economists now expect bank rate path to be slightly delayed. So we are now expecting Bank of England to hike in July and September versus previously expecting June and July.

And still, the risk is that only one hike from Bank of England gets delivered this year. And then we continue to expect quarterly cuts from the second quarter of 2027 to a terminal rate of 3.5% to be reached by end of 2027. So where do we think we go from here in Gilt Yields?

It's not a clear-cut answer, but the way I would frame my answer is in two ways. So to assess the extent of fiscal concerns priced in, because I think that's very important, we can look at the residual of global 1030s curves based on principal component analysis. And when taking into account Germany, U.S., U.K. and Japan, U.K. residual remains around 5 to 10 basis points above pre-March levels, which suggests that you have some scope for further flattening on the long end of the curve.

But having said that, political uncertainty is likely to persist into 18th June maker field by-election and potentially beyond. And then second, bank rate expectations are another key driver of the long end of the Gilt Curve and the relationship between two-year yields and 1030s, which actually, since mid-April, shows curve steepness being elevated at any level of two-year yields. For this framework, a dovish repricing towards only one Bank of England hike, which would be our risk scenario, would imply around five basis points of additional steepening in 1030s.

And conversely, a hawkish shift back to three hikes being priced in. For example, if BOE were to surprise us with a June hike, that would lead to more hikes being priced in further out. That would likely generate bear-flattening pressures on 1030s.

So I would look to this two-way framework of considering the front-end relationship to the long end, as well as fiscal concerns pricing in. Thank you, Agni. And finally, switching to the euro area, Edward, what do you think is most significant for wind yields?

Yes, I'd say, of course, in Europe, much like elsewhere, the sell-off has been driven primarily by the repricing of the central bank policy outlook. But there has been a region-specific topic here, which we do believe has led to some of the cheapening as well. So unlike in the US and the UK, we expect an increase in net supply to private investors in 2026.

And additionally, after some initial hesitation, immediately following the escalation, many sovereigns are now running behind the issuance pace versus last year's. So meaning that the volume then of supply for the remainder of the year is now greater than what was initially assumed. We believe the market has been increasingly pricing in those supply concerns, as we can see this both in investor service, but also in the increased residual steepness of the German two-year tenure curve after accounting for joint global curve dynamics.

Lastly, we've also seen a buildup of net short positioning, especially in the German five-year and ten-year futures. Since the start of March, we'll, of course, also have added to the cheapening pressures. How has the outlook evolved over this past week and what helped really a bit of the rally?

So of course, the core themes still remain, and prices still lead the way. With an ECB that, however, seems to be a bit more balanced now in its assessment of inflation risks. We also think supply pressures are not really expected to disappear, but they are set to slow a bit overall in the summer, and fast money positioning may be a bit more balanced now following the sharp sell-off in Friday to Tuesday.

But what's perhaps more interesting, and what I assume you're leaning to, is the signs of weakness in underlying growth that we are getting, especially there with the soft PMIs were particularly relevant for the markets this week. Moir, would you say we're heading towards now for ten-year booms? Yes.

So we think this 3 to 10, 3 to 20 mark in ten-year boom yields is likely the upper end of what we should expect in 2026. As for the market to reprice meaningfully higher from here, we would need to see one or two things in our opinion, neither of which look particularly likely. So the first would be that rates and markets would have to move towards pricing closer to 100 bps of ECB hikes without growth sentiment deteriorating, which would be a material shift, as it would likely require meaningful escalation or unexpectedly strong second round effects that forces the ECB's hand.

On top of that, we also expect underlying inflation and growth dynamics to continue softening as the year progresses, conditions that typically make it a lot more difficult for the market to sustain a more aggressive hiking path. And if the hikes still get priced in, we believe it would increasingly instead then have a bear flattening effect. Second, boom yields could push higher if expectations of materially higher German supply were to build, but here as well, the bar looks quite high.

So as I mentioned earlier, the market already appears to be discounting some of the supply pressures. Additionally, German infrastructure and defense spending does not look to be rapidly expanding. And on the contrary, it may pose some downside risk in supply expectations.

Instead, we think the upside risk from supply largely stems from downward risk to growth and should therefore be generally less negative for booms. So over time, we do think this sort of eventual inflation under the weak underlying growth should help booms eventually be priced at lower yields. Thank you, Edward.

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